Pensions – Page 2 – The Aleph Blog

Thinking About Pensions, Part 2

Posted on 15 August 201516 August 2015 by David Merkel

In part 1, I went through some of the history of defined benefit [DB] pensions using a Q&A format. I’m going to continue that in part 2.

Q:?What are we supposed to do about pension policy in the US?then?

A: Let me start with a quotation from an old article of mine,?Replacing Defined Contributions.

Pension plan reform has to face three realities.? The first is people don?t know how much to put away for retirement.? I?ll give you a hint: for almost all people, it should be over 10% of your gross pay.? The second is that people don?t know how to invest, so hand it off to advisors who will do it for them, and cheaply.? The third is silent, and leaves a lot of money on the table ? most people would be better off taking an annuity from their pension plan than a third party, or trying to manage a lump sum on their own.? This is usually an option only for defined benefit [DB] plans.

It would be nice if we could give everyone a DB plan, but as I pointed out last time, the costs would be too high. ?DC [Defined Contribution] plans are inexpensive enough, but they have the above three flaws.

Q: How could we get people and firms to save more for retirement?

A: I’m not sure you can. ?Present needs are large for many people, and they can’t imagine saving anything over 3%, much less 10%+ of pay. ?Firms could do more, but it would raise costs, unless it is taken out of other benefits or wages.

Q: Why not “nudge” people to save more — create something that shows how far they are behind their most prudent peers?

A: Think about high school for a moment. ?It’s a very peer conscious part of life for many people. ?How well would an appeal go over asking the bulk of students to behave well, like the best-behaved students in the class?

Q: It might affect a few, but for the most part people are set in their ways. ?They’ve already done their own implicit comparisons, and concluded that they are doing well enough relative to the peers they care about, given the circumstances. ?They also might not like the comparison and say something like, “Fine for them, but I have different realities in my life.”

A: Right. ?Effects should be small.

Q: Why not force people to save 10% of their pay then?

A:?I think that treats adults like kids. ?If they don’t want to save, let them be. ?They might regret it later, or, they might say, “This is my lot in life. ?I have to take care of what I think is important now, and when I am old, I’ll work if I have to.” ?Also, people have an incredible ability to ignore reality if they need to.

Q: But isn’t there a public policy reason to encourage retirement plans and savings?

A: Most politicians think so, but retirement is a modern concept that with longer lifespans may not make sense in every situation. ?The generation that fought WWII had a unique situation that allowed many of them to retire very comfortably that we don’t have now. ?Productivity increases were larger, the demographics were right, global labor competition was a lot lower, and investment returns were a lot better.

You could look at my piece,?Ancient and Modern: The Retirement Tripod?for more on this. ?As it is, it will be difficult to take care of the Baby Boomers to the same degree that their parents were taken care of — it doesn’t matter how you fund it — it is a humongous claim on GDP, and what will be left for those who are younger?

Q: So, you argue for freedom to choose in contributions, but you don’t argue for it in investing or distributions?

A: Uh, yes. ?The main difference is that I think most people are capable of estimating their tradeoff of money now versus money in the future, and they are implicitly saying they don’t want to retire, regardless of what they say explicitly.

On investing, most people do not know what to do, and I would strip down most DC plans down to a small bunch of blended funds managed by professionals getting paid at low institutional rates. ?There would be at most five funds, ranging from conservative to aggressive, with a default option that adjusts which fund a participant is in based on age.

On distributions, no one, not even professionals, are good at managing a lump sum of money to provide a stream of income. ?Dig the ten reasons for that in this article. ?People are capable of budgeting, so give them a fixed or slowly rising income to live off of, while investing their slack assets to cover future increases in costs.

Q: It seems inconsistent to me.

A:?I’m just trying to be realistic about what people are capable of doing, and what their needs are.

Q: Why not have the government do the investing, or invest all pension monies in government debt?

I don’t think it is wise to entrust so much of the investing in the economy to a single entity. ?Backdoor socialism is a real risk here. ?Nor is it wise to fund the government via pensions. ?Note how well the government did with Social Security. ?It would be one thing if the government had used the money to improve infrastructure, but the money was generally spent on current consumption.

Q: The CFA Institute has put out their own plans for an Ideal Retirement System. ?Wouldn’t that be a good idea?

A: When I was a kid, one of my friends would say to me, “If wishes were fishes, we’d all have a big fry.” ?Like giving everyone?a strong DB plan — it fails the cost test. ?You could start doing this for a new group of retirees that would retire in the 2060s and beyond, but it is unrealistic for the present cohorts looking to retire sooner that have not saved enough individually or corporately.

Q: This is pretty dour. ?Don’t you have anything encouraging to say here?

A: I would note that elderly people tend to be happier than younger people. ?Some of it is coming to terms with life, grasping that many of the things that we aimed for when we were younger weren’t worth it, and taking some satisfaction in what good you have in the present. ?It’s not all money based, but certainly money helps. ?Some will look back at the past and say they did what was best for all their responsibilities. ?Others may regret missed opportunities.

There may be some good that comes out of the American tendency toward voluntarism. ?Who knows what elderly Baby Boomers might do when they put their mind to it? ?Hopefully it won’t be voting more money for themselves from the public purse.

Q: Any final advice?

A: You are you own best guardian of your own retirement. ?I encourage you to:

Save what you can. ?This is one factor you can control.
Invest prudently, keeping fees low. ?Don’t let yourself give into greed or fear.
Use immediate annuities to provide a minimum amount of income, and other assets for growth.
Make sure that you have younger friends to watch out for you. ?Every older person needs advocates that can watch out for their best interests.

Thinking About Pensions, Part 1

Posted on 8 August 20159 August 2015 by David Merkel

Dear Readers, I’m going to try a different format for this piece. If you think it is a really bad way to present matters, let me know.

Question: Why do pensions exist?

Answer: They exist as a means of incenting employees to work for a given entity. ?It can be a very valuable benefit ?to employees, because it is difficult to earn money in old age.

Q: How did we end up with retirement savings being predominantly associated with employment?

A: That’s mostly an accident of history. ?First some innovative firms offered defined?benefit [DB] plans [paying a fixed sum at retirement for life, often with benefits to surviving spouses, and pre-retirement death benefits] in order to attract employees. ?After World War II, many unions insisted and won such benefits, and many non-union firms imitated them.

Q: Why didn’t many defined benefit plans persist to the present day?

A: In general, they were too expensive.

Q: If they were too expensive, why did they get created?

A: They weren’t expensive at first. ?The post-WWII era was one of booming demand and excellent demographics — there was only a small cohort of oldsters to support, and a rapidly growing population of workers. ?Also, the funding mechanisms allowed by the government allowed for low levels of initial funding to get them started, and they assumed that corporations would easily catch up at some later date. ?Sadly, some of the funding was so low that there were some defaults in the 1960s, leaving pensioners bereft.

Q: Ouch. ?What happened as a result?

A: Eventually, Congress passed the?Employee Retirement Income Security Act in 1974. ?That standardized pension funding methods and tightened them a little, but not enough for my taste. ?It also created the Pension Benefit Guarantee Corporation to insure defined benefit plans. ?It did many things to standardize and protect defined benefit pensions. ?Protection comes at a cost, though, and costs went higher for DB plans.

Some firms began terminating their plans. ?In the mid-1980s, some firms found that they could get a moderate profit out of terminating their plans. ?That didn’t sit well with Congress, which passed legislation to inhibit the practice. ?That indirectly inhibited starting plans — few people want to in the “in” door, when there is not “out” door.

Some firms began funding their plans very well, and the IRS didn’t like the loss of tax revenue, so regulations were created to stop overfunding of pension plans. ?These regulations put sponsors in a box. ?Given the extremely strong asset returns of the ’80s and ’90s, it would have made sense to salt a lot of assets away, but that was not to be. ?Thanks, IRS.

Q: Were there any other factors aside from tax policy affecting DB plans?

A: Four?factors that I can think of:

Falling interest rates raised the value of pension liabilities.
Demographics stopped being so favorable as people married less and had fewer kids.
Actuaries got pressured to be too aggressive on plan valuation assumptions, leading to lower contributions by corporations and municipalities to their plans.
By accident, the 401(k) was introduced, leading to an alternative pension plan design that was a lot cheaper. ?Defined contribution plans were a lot cheaper, and easier for participants to understand. ?The benefits were valued more than the technically superior DB plan benefits because you could see the balance grow over time — especially in the ’80s and ’90s!

Q: Why do you say that?DB plan benefits were?technically superior?

A: Seven?reasons:

They were generally paid for entirely by the employer.
A lot more money was contributed by the employer.
It gave them a benefit that they could not outlive.
Average people aren’t good at investing.
Fees for investing were a lot lower for DB plans than for Defined Contribution [DC] plans. ?(Employer provides a sum of money to each employee’s account.)
The institutional investors were better for DB plans than DC plans, because plan sponsors would go direct to money managers with talent, while plan participants demanded name-brand mutual funds that were famous. ?(Famous means a lot of assets recently added, which means poor future performance. ?Should you give your kids what they want, or what you know they need?)
If the companies could continue to afford the benefits, the benefits would be much larger in present value terms than the lump sum accumulated in their DC plans.

The last point is important, because the benefits promised were too large for the companies to fund. ?Eventually, they will be too large for most states and municipalities to fund as well, but that’s another thing…

Q: So?people preferred something that was easier to understand, rather than something superior, and companies used that to shed a more expensive pension system. ?That’s how we got where we are today?

A: Yes, and add in the relative impermanence of most corporations and some industries. ?You need a strong profit stream in order to fund DB plans.

Q: What are we supposed to do about this then?

A: Stay tuned for part two, which I will write next week. ?Believe me, there are a lot of controversial ideas about this, and there are no easy solutions — after all, we got into this problem because most corporations and people did not want to save enough money for the retirement of employees and themselves, respectively.

Q: Till next time, then!

Why Life Insurers, Defined Benefit Plans, and Endowments Invest Differently

Posted on 25 April 2015 by David Merkel

Despite the large and seemingly meaty title, this will be a short piece. ?I class these types of investors together because most of them have long investment horizons. ?From an asset-liability management standpoint, that would mean they should invest similarly. ?That may be have been true for Defined Benefit [DB] pension plans and Endowments, but that has shifted over time, and is increasingly not true. ?In some ways, the DB plans are becoming more like life insurers in the way they invest, though not totally so. ?So, why do they invest differently? ?Two reasons: internal risk management goals, and the desires of insurance?regulators to preserve industry solvency.

Let’s start with life insurers. ?Regulators don’t want insolvent companies, so they constrain companies into safe assets using risk-based capital charges. ?The riskier the investment, the more capital the insurer has to put up against it. ?After that, there is cash-flow testing which tends to push life insurers to match assets and liabilities, or at least, not have a large mismatch. ?Also, accounting rules may lead insurers to buy assets where the income will show up on their financial statements regularly.

The result of this is that life insurers don’t invest much in risk assets — maybe they invest in stocks, junk bonds, etc. up to the amount of their surplus, but not much more than that.

DB plans don’t have regulators that care about investment risks. ?They do have plan sponsors that do care about investment risk, and that level of care has increased over the past 15?years. ?Back in?the late ’90s it was in vogue for DB plans to allocate more and more to risk assets, just in time for the market to correct. ?(Note to retail investors: professionals may deride your abilities, but the abilities of many professionals are questionable also.)

Over that time, the rate used to discount DB plan liabilities became standardized and attached to long high quality bonds. ?Together with a desire to minimize plan funding risks, and thus corporate risks for the plan sponsor, that led to more investments in bonds, and less in equities and other risk assets. ?Some plans try to cash flow match expected future plan payments out to a horizon.

Finally, endowments have no regulator, and don’t have a plan sponsor?that has to make future payments. ?They are free to invest as they like, and probably have the highest degree of variation in their assets as a group. ?There is some level of constraint from the spending rules employed by the endowments, particularly since 2008-9, when a number of famous endowments came to realize that there was a liability structure behind them when they ran low on liquidity amid the crisis. [Note: long article.] ?You might think it would be smart to have the present value of 3-5?years of expenditures on hand in bonds, but that is not always the case. ?In some ways, the quick recovery taught some endowment investors the wrong lesson — that they could wait out any crisis.

That’s my quick summary. ?If you have thoughts on the matter, you can share them in the comments.

On Human Fertility, Part 4

Posted on 2 April 2015 by David Merkel

I write about this every now and then, because human fertility is falling faster then most demographers expect. Using the CIA Factbook for data, the present total fertility rate for the world is 2.425 births per woman that survives childbearing. That is down from 2.45 in 2013, 2.50 in 2011, and 2.90 in 2006. At this rate, the world will be at replacement rate (2.1), somewhere between 2025 and 2030. That?s a lot earlier than most expect, and it makes me suggest that global population will top out at 8.5 Billion in 2050, lower and earlier than most expect.

Have a look at the Total Fertility Rate by group in the graph above. The largest nations for each cell are listed below the graph. Note Asian nations to the left, and African nations to the right.

Africa is so small, that the high birth rates have little global impact. Also, AIDS consumes their population, as do wars, malnutrition, etc.

The Arab world is also slowing in population growth. When Saudi Arabia is near replacement rate at 2.17, you can tell that the women are gaining the upper hand there, which is notable given the polygamy is permitted.

In the Developed world, who leads in fertility? Israel at 2.62. Next is France at 2.08 (Arabs), New Zealand at 2.05, and the US at 2.01,?slightly below replacement. We still grow from immigration, as does France.

Most of the above is a quick update of my prior piece, which has some additional crunchy insights. ?This evening, I would like to highlight two articles that I saw recently — one on troubles with municipal pensions, and one on how some areas of China are dying. ?They are at root the same story, but with different levels of potency.

Let me start with the?amusing question where?Arnold Schwarzenegger asks Buffett via CNBC what can be done to solve the municipal defined benefit pension problem, which Becky Quick then asks Buffett. ?For the next 80 seconds, Buffett says it is a messy problem created by politicians that voted for high municipal pensions, because future generations would pay the bill, and not current taxpayers. ?The politicians that voted for them are long gone. ?Buffett offers no solutions, and I don’t blame him because all of the solutions are ugly. ?Here they are:

If state law allows, terminate the current plans and replace them with Defined Contribution plans, or reduce the rates of future accrual. ?If those can’t be done, create a new Defined Contribution plan for all new employees, who will no longer participate in the?Defined?Benefit plans. ?Even the last of these will be fiercely resisted by municipal unions.
Cancel the cost of living adjustment, if you can do so legally.
Raise taxes — I’m sure younger people will enjoy paying for past services of municipal employees.
Impose excise (or something like that) taxes on municipal pension payments, and rebate the money back to the plans.
Declare or threaten bankruptcy if you can legally do it, and try to extract concessions from the representatives of pensioners.
Amend the state constitution to change the status of pension benefits, including adding an?exception adding legality to adjust benefits after the fact. (ex post facto)

Don’t get me wrong. ?I don’t think the radical solutions could/would ever be done, and the National government would probably slap down any state that actually tried something draconian. ?Remember, states are practically administrative units of the national government. ?States’ rights is a nice phrase, but often very empty of power.

Here are some non-solutions:

Float pension bonds — just a form of leverage, substituting a fixed liability for a contingent liability, and assuming that you can earn more than the?rate paid on the pension bonds.
Invest more aggressively. ?Sorry, taking more risk won’t do it. ?Returns are only weakly related to risk, and often taking high risks leads to lower returns. ?The returns you are likely to get depend mostly on the entry prices you pay for the underlying cash flow streams in question.
Invest in alternative assets. ?Sorry, you are late to the game. ?Alternatives offer little more than conventional assets at present, and they carry high fees and illiquidity.
Adjust the discount rate, or salary increase rate assumption. ?That may make the current problem look smaller, but it doesn’t change the underlying benefits to be paid, or the returns the assets will earn. ?If anything, the assumptions are too aggressive now, and plan assets are unlikely to return much more than 4%/year over the next 10 years.

Buffett gave one cause for the problem, but there is one more — if the US population were growing rapidly, there would be a larger base of taxpayers to spread the taxes over. ?Diminished fertility feeds into the problems in the states, as well as other social insurance schemes, like Social Security and Medicare. ?You could loosen up immigration to the US, particularly for younger, wealthy, and or/skilled people, but that has its controversial aspects as well.

Here’s another way of phrasing it — it’s difficult to create workers out of thin air. ?Governments would like nothing better than to?have more working age people magically appear. ?It would solve the problem. ?Alas, those decisions were largely made 20-40 years ago also. ?There is even competition now for the best immigrants.

That brings me to the article on China. Rudong, a city in China where the one-child policy began, is now an elderly place with few younger people to take care of the elderly. ?Kind of sad, even if the problem was partially self-inflicted, and partially inflicted by conceited elites who thought they were doing a good thing.

A few?quotations from the article:

?China will see more places like Rudong very soon,? said Wang Feng, a professor of sociology at the University of California at Irvine. ?It?s a microcosm of the rapid demographic and economic transformation China has been experiencing the last decades. There will be more ghost villages and deserted or sleepy towns.?

also:

?China is quickly turning gray on an unprecedented scale in human history, and the Chinese government, even the whole Chinese society, is not prepared for it,? Yi said. ?In many places, including my hometown in western Hunan, it?s hard to find a young man in his 20s or 30s.?

and also:

What?s different in China is that the one-child policy accelerated the process, removing hundreds of millions of potential babies from the demographic pool. China?s old-age dependency ratio ? a measure of those age 65 or over per 100 of working age ? is set to triple by 2050, to 39.

The one-child policy created possibly the sharpest demographic shift in the world. ?It is largely irreversible; once women as a culture stop having children, they don’t start having more when benefits are offered or penalties are lowered. ?It would take a big change in mindset in order to get that to shift, like a religious change, or the aftermath of a big war.

The Christians are growing in China, and many of them would have larger families, but even if Christianity?gets a lot bigger, and the Party tolerates it, that won’t come fast enough to deal with the problems of the next 30 years, but it could help with the problems after that.

In closing, there is enough pity to go around. ?Pity for the elderly that will not get taken care of to the degree that they would like. ?Pity for those younger who cannot afford the time or monetary costs of taking care of the elderly.

I think the only solution to any of this would be shared sacrifice, where everyone gets hurt somewhat. ?My question would be what places in the world have the requisite maturity to?achieve such a solution. ?Optimistically, the answer would be many, but only after a lot of sturm und drang.

Advice on Organizing Asset Allocations and Managers

Posted on 26 February 2015 by David Merkel

I was reading an occasional blast email from my friend Tom Brakke, when he mentioned a free publication from Redington, a UK asset management firm that employs actuaries, among others. I was very impressed with what I read in the 32-page publication, and highly recommend it to those who select investment managers or create asset allocations, subject to some caveats that I will list later in this article.

In the UK, actuaries are trained to a higher degree to deal with investments than they are in the US. The Society of Actuaries could learn a lot from the Institute of Actuaries in that regard. As a former Fellow in the Society of Actuaries, I was in the vanguard of those trying to apply actuarial principles to risk management, both when I managed risks for insurance companies, worked for non-insurance organizations, and manage money for upper middle class individuals and small institutions. Redington’s thoughts are very much like mine in most ways. As I see it, the best things about their investment reasoning are:

Risk management must be both quantitative and qualitative.
Risk is measured relative to client needs and thus the risk of an investment is different for clients with different needs. ?Universal measures of risk like Sharpe ratios, beta and standard deviation of asset returns are generally inferior measures of risk. ?(DM: But they allow the academics to publish! ?That’s why they exist! ?Please fire consultants that use them.)
Risk control methods must be?implemented by clients, and not countermanded if they want the risk control to work.
Shorting requires greater certainty than going long (DM: or going levered long).
Margin of safety is paramount in investing.
Risk control is more important when things are going well.
It is better to think of alternatives in terms of the specific risks that they pose, and likely future compensation, rather than look at track records.
Illiquidity should be taken on with caution, and with more than enough compensation for the loss of flexibility in future asset allocation decisions and cash flow needs.
Don’t?merely avoid risk, but take risks where?there is more than fair compensation for the risks undertaken.
And more… read the 32-page publication from Redington if you are interested. ?You will have to register for emails if you do so, but they seem to be a classy firm that would honor a future unsubscribe request. ?Me? ?I’m looking forward to the next missive.

Now, here are a few places where I differ with them:

Caveats

Aside from pacifying clients with lower volatility, selling puts and setting stop-losses will probably lower returns for investors with long liabilities to fund, who can bear the added volatility. ?Better to try to educate the client that they are likely leaving money on the table. ?(An aside: selling short-duration at-the-money puts makes money on average, and the opposite for buying them. ?Investors with long funding needs could dedicate 1% of their assets to that when the payment to do so is high — it’s another way of profiting from offering insurance in of for a crisis.)
Risk parity strategies are overrated (my arguments against it here:?one, two).
I think that reducing allocations to risky assets when volatility gets high is the wrong way to do it. ?Once volatility is high, most of the time the disaster has already happened. ?If risky asset valuations show that the market is offering you significant deals, take the deals, even if volatility is high. ?If volatility is high and valuations indicate that your opportunities are average to poor at best, yeah, get out if you can. ?But focus on valuations relative to the risk of significant loss.
In general, many of their asset class articles give you a good taste of the issues at hand, but I would have preferred more depth at the cost of a longer publication.

But aside from those caveats, the publication is highly recommended. ?Enjoy!

On Financial Risk Statements, Part 1

Posted on 13 December 2014 by David Merkel

Most formal statements on financial risk are useless to their users. Why?

They are written in a language that average people and many regulators don’t speak.
They often don’t define what they are trying to avoid in any significant way.
They don’t give the time horizon(s) associated with their assessments.
They don’t consider the second-order behavior of parties that are managing assets in areas related to their areas.
They don’t consider whether history might be a poor guide for their estimates.
They don’t consider the conflicting interests and incentives of the parties that?direct the asset managers, and how their own institutional risks affect their willingness to manage the risks that other parties deem important.
They are sometimes based off of a regulatory view of what can/must be stated, rather than an economic view of what should be stated.
Occasionally, approximations are used where better calculations could be used. ?It’s amazing how long some calculations designed for the pencil and paper age hang on when we have computers.
Also, material contract provisions that are hard to model/explain often get ignored, or get some brief mention in a footnote (or its equivalent).
Where complex math is used, there is no simple language to explain the economic sense of it.
They are unwilling to consider how volatile financial processes are, believing that the Great Depression, the German Hyperinflation, or something as severe, could never happen again.

(An aside to readers; this was supposed to be a “little piece” when I started, but the more I wrote, the more I realized it would have to be more comprehensive.)

Let me start with a brief story. ?I used to work as an officer of the Pension Division of Provident Mutual, which was the only place I ever worked where analysis of risks came first, and was core to everything else that we did. ?The mathematical modeling that I did in there was some of the best in the industry for that era, and my models helped keep us out of trouble that many other firms fell into. ?It shaped my view of how to manage a financial business to minimize risks first, and then make money.

But what made us proudest of our efforts was a 40-page document written in plain English that ran through the risks that we faced as a division of our company, and how we dealt with them. ?The initial target audience was regulators analyzing the solvency of Provident Mutual, but we used it to demonstrate the quality of what we were doing to clients, wholesalers, internal auditors, rating agencies, credit analysts, and related parties inside Provident Mutual. ?You can’t believe how many people came to us saying, “I get it.” ?Regulators came to us, saying: “We’ve read hundreds of these; this is the first one that was easy to understand.”

The 40-pager was the brainchild of my boss, who was the most intuitive actuary that I have ever known. ?Me? I was maybe the third lead investment risk modeler he had employed, and I learned more than I probably improved matters.

What we did was required by law, but the way we did it, and how we used it was not. ?It combined the best of both rules and principles, going well beyond the minimum of what was required. ?Rather than considering risk control to be something we did at the end to finagle credit analysts, regulators, etc., we took the economic core of the idea and made it the way we did business.

What I am saying in this piece is that the same ideas should be more actively and fully applied to:

Investment prospectuses and reports, and all investment and insurance marketing literature
Solvency documents provided to regulators, credit raters, and the general public by banks, insurers, derivative counterparties, etc.
Risk disclosures by financial companies, and perhaps non-financials as well, to the degree that financial markets affect their real results.
The reports that sell-side analysts write
The analyses that those that provide asset allocation advice put out
Consumer lending documents, in order to warn people what can happen to them if they aren’t careful
Private pension and employee benefit plans, and their evil twins that governments create.

Looks like this will be a mini-series at Aleph Blog, so stay tuned?for part two, where I will begin going through what needs to be corrected, and then how it needs to be applied.

Stay Calm

Posted on 5 November 2014 by David Merkel

Photo Credit: Moyan Brenn || Relax, you know less than you think... — Photo Credit: Moyan Brenn || Relax, you know less than you think…

So, the Republicans swamped the Democrats in the midterm elections.

Big deal.

The differences between the varying wings of the Purple Party are smaller than you think. ?What’s more, their willingness to magnify those differences and do little as a result is a high probability outcome.

Add in that the Republicans don’t have a coherent set of policies as a group. Will the t-party and Establishment wings of the GOP come to a meeting of the minds? (Democrats may insert easy cheap joke here.) ?Even if they do, who will take the blame when Obama vetoes their bills? ?They aren’t called the “stupid party” for nothing. ?They have a peculiar knack for snatching defeat from the jaws of victory, and letting their less presentable members define them.

Even if in theory, the markets do better from Republicans, in practice the reverse seems to be true. ?But the track record has so few data points that statistical credibility is low.

And, if there is something to the Republicans being in power moving the markets, how would you know if it wasn’t anticipated in the recent run-up of prices? ?Many parties may have bought into the concept of greater prosperity as result of the then-forthcoming elections. ?The time to buy?the rumor is gone. ?The time to sell the news may be here.

The same applies to the presidential cycle. ?Many argue that we are heading into a good time for the markets in the third and fourth year of a presidential term. ?Too many are arguing this in my opinion, and even if there is some real impact from presidential terms, perhaps the market is anticipating this as well. ?After all, the bad part of the presidential cycle looked pretty good this time around.

Add in that again we are working with the law of small numbers — the presidential cycle could just be due to?randomness. ?Some part of the presidential cycle had to look better. ?Is it so much better than any other subset could have been?

The same thing applies to the argument I am seeing trotted around that we are coming into the best six months?of the year. ?Cue the comments on the law of small numbers and randomness. ?Even if there is a structural reason like tax-based selling, might it have been anticipated this time around? ?Markets tend to anticipate. ?Some six month period had to be best… but is it due to randomness?

Going back to politics, I would point out that few significant things change in politics off of party affiliation. ?How many states have their budgets balanced on an accrual basis, taking into account the need to spread out the cost of infrastructure projects, and?pensions funded assuming a realistic 5% earnings assumption on assets, together with fully funded accrual accounts? ?None. ?All of the states put off paying for the accruals of what should be current expenses.

We’ve talked about entitlement reform, but action never happens, except further expansion, as under Bush, Jr. ?Will we see GSE reform, or will Congress continue to use the GSEs for their own ends? ?Will there ever be significant cuts in defense? ?Will we ever see truly balanced budgets on an accrual basis?

Beyond that, consider the Fed, the Supreme Court, and the bureaucracy generally… they don’t change rapidly, if at all. ?Admittedly, the Supreme Court has been more activist over the recent past… so maybe I am wrong there.

And truly, Congress changes only at the edges. ?The grand majority?of the same faces will be there, only the majority and committee assignments shift. ?That may not mean much.

But do we want lots of change? ?Individually, many of us do, but if you add us all together, it often nets to something near zero. ?Perhaps most of us are happy with that, given the alternative that those of us with the opposite views might impose them on the rest of us.

I leave you with this: don’t make too much out of the election results, the presidential cycle, the “sell in May and go away” phenomenon, etc. ?The world is complex, with many people trying to anticipate market reactions. ?Untangling them is close to impossible, so stay calm, and pursue the ordinary strategies that you always do. ?For me, I will continue my value investing.

Managing Money for Retirement

Posted on 9 October 20149 October 2014 by David Merkel

Photo Credit: eric731 -- People can budget, but can they manage risk? — Photo Credit: eric731 — People can budget, but can they manage risk?

Investing is difficult. ?That said, we can make it harder still. ?We can encourage people with little to no training to try to do it for themselves. ?Sadly, many people get caught in the fear/greed cycle, and show up at the wrong time to buy and/or sell. ?We get there late, and then our emotions trick us into action, when the rational investor says, “Okay, I missed that move. ?Where are there opportunities now, if there are any at all?”

But investing can be made even more difficult. ?Investing reaches its most challenging level when you are relying on your investing to meet an anticipated and repeated need for cash outflows.

Institutional investors will tell you, portfolio decisions are almost always easier when there is more cash flowing in than flowing out. ?It means that there is one dominant mode of thought: where to invest?new money? ?Some attention will be given to managing existing assets — pruning away assets with less potential, but the need won’t be as pressing. ?(Note: at really high rates of cash?inflow, investing gets really tough as well, but that’s another story, and one that I successfully lived though 1998-2003…)

What’s tough is trying to meet a?cash withdrawal?rate that is materially higher than what can safely be achieved over time, and earning enough?consistently to do so. ?Doing so as an amateur managing your own retirement portfolio will be a particularly hard version of this problem. ?Let me point out some of the areas where it will be hard:

1) You don’t know how long you, your spouse, and anyone else relying on you will live. ?Averages can be calculated, but particularly with two people, the odds are that one will outlive an average life expectancy. ?Can you be conservative enough in your withdrawals that you won’t outlive your money?

2) My estimate of what the safe withdrawal rate is on a perpetuity is the yield on the 10-year Treasury Note plus around 1%. ?That additional 1% can be higher after the market has gone through a bear market, and valuations are cheap, and as low as zero when you are near the end of a bull market.

Now, most?people people with discipline want a simple spending rule, and so those that are moderately conservative choose that they can spend 4%/year of their assets. ?At present, if interest rates don’t go lower still, that will likely (60-80% likelihood) work. ?But if your income needs are greater than that, your odds of yields over the long haul go down dramatically.

3) Will you be able to maintain an iron discipline, and not overspend your assets? ?It’s tempting to do so, and the temptation will get greater when bad events happen that break the budget, whether those are healthcare or other needs. ?It is incredibly difficult to?avoid paying for an immediate pressing need, when the soft cost?is harming your future. ?There is every incentive to say, “We’ll figure it out later.” ?The odds on that being true will be low.

4) How will you deal with bear markets, particularly ones that occur early in retirement? ?Can?you and?will you reduce your expenses to reflect the losses? ?On the other side, during bull markets, will you build up a buffer, and not get incautious during seemingly good times?

This is an easy prediction to make, but after the next bear market, look for a scad of “Our retirement is ruined articles.” ?Look for there to be hearings in Congress that don’t amount to much — and if they do amount to much, watch them make things worse by creating R Bonds, or some garbage like that.

5)?Avoid investing in too many income vehicles; the easiest temptation to give into is to stretch for yield — it is the oldest scam in the books. ?This applies to dividend paying common stocks, and stock-like investments like REITs, MLPs, BDCs, etc. ?They have no guaranteed return of principal. ?On the plus side, they may give you capital gains if you use them right, buying them when they are out of favor, and reducing exposure when everyone is buying them.

Another easy prediction to make is that junk bonds and non-bond income vehicles will be a large contributor to the shortfall in asset return in the next bear market, because a decent number of people are buying them as if they are magic. ?The naive buyers think: all they do is provide a higher income, and there is no increased risk of capital loss.

6) Avoid taking too much?or too little risk. It’s psychologically difficult to buy risk assets when things seem horrible, or sell when everyone else is carefree. ?If you can do that successfully, you are rare. ?What is achievable by many is to maintain a constant risk posture. ?Don’t panic; don’t get greedy — just stick to your investment plan through the cycles of the markets.

7) As assets shrink, what will?you liquidate? ?The best thing would be?being forward-looking, and liquidating what has the lowest risk-adjusted future return. ?What is achievable is selling assets off from everything proportionally, taking account of tax issues where needed.

8 ) Are you ready for Social Security to take a hit out around 2026? ?Once the trust fund gets down to one year’s worth of?payments, future payments get reduced to the level?sustainable by expected future contributions. ?Expect a political firestorm when this becomes a live issue, say for the 2024 Presidential election. ?There will be a bloc of voters to oppose leaving benefits unchanged by increasing Social Security taxes.

9) Be wary of inflation, but don’t overdo it. ?The retirement of so many people may be deflationary — after all, look at Japan and Europe so far. ?Economies also work better when there is net growth in the number of workers. ?It will be tempting for policymakers to shrink what liabilities they can shrink through inflation, but there will also be a bloc of voters to oppose that.

10) You need a defender of two against slick guys who will try to cheat you when you are older. ?If you have assets, you are a prime target for scams. ?Most of these come dressed in suits: brokers and other investment salesmen with plausible ways to make your money stretch further. ?But there are other scams as well — run everything significant past a smart younger person who is skeptical, and knows how to say no when needed.

Conclusion

If this all seems unduly dour (and I haven’t even talked about defined benefit plan issues), let me tell you that this?is realistic. ?There are not enough resources to give all of the Baby Boomers a lush retirement, without unduly harming younger age cohorts, and this is true over most of the developed world, not just the US.

Even with skilled advisers helping you, you need to be ready for the hard choices that will come up. ?Better you should think through them earlier rather than later. ?Who knows? ?You might take some actions that will lower your future risks. ?More on that in a future post, as well as the other retirement risk issues.

Social Security Troubles

Posted on 31 July 2014 by David Merkel

We have known for many years that Social Security’s Disability Trust Fund was in far worse ?shape than the Retirement Trust Fund, which is also not in good shape. ?The rolls for?Social Security Disability have risen dramatically since 2009, with many applying for disability amid a time where jobs are hard to find. ?Personally, I think that people should plan for their own possible disability, and it not be something that the government covers.

That said, the disability trust fund will run out of money in 2016. ?The most likely result in my opinion, is that ?the disability trust fund will borrow from the the retirement trust fund, accelerating the insolvency of the retirement trust fund, currently scheduled to?make a change to payments in 2026, when it has only one year of payments left in the trust fund, and will have to pro-rate all payments, so that the payments will be made from existing tax payments plus assets on hand. ?This means that social security retirement and disability payments will be cut by around 27%.

The politics of this is complicated, and I don’t pretend to have an absolute answer to how this will all work out. ?My past dealings with these issues indicate that if the problem can be deferred, it will be deferred. ? Borrowing from the retirement trust fund ruffles few feathers, and allows politicians 10 years or so of breathing room, after whichthey may have resigned or retired.

At some point in the future the following phrase will be common: “You got what you deserved, because you trusted the government.” ?Add in the troubles at Medicare, where the trust fund also will run out before 2020.

If you are relying on Social Security, you are in a bad spot, ?Either taxes will be raised, or benefits will be cut, either across-the-board, or selectively.

This will be a fight, as most other things in our government budget are, and there is no telling how it will turn out. ?There is only one certain thing: if we had dealt with this 25-35 years ago, we would not be in this pickle now. ?Shame on our parents’ generation, and shame on us, if you are over age 35. ?More guilt to those who are older.

On Learning Compound Interest Math

Posted on 19 July 201420 July 2014 by David Merkel

When I read articles like?this where people get scammed borrowing money, I say to myself, “we need to teach children the compound interest math.”

Even my dear wife does not get it, and she sends the children to me when they don’t get it. ?But beyond learning the math, a healthy skepticism of borrowing needs to be encouraged, especially for depreciating items like autos.

The compound interest math is really one of the more simple items of Algebra 2. ?Everyone should be able to calculate the value of a non-contingent annuity at a given interest rate.

Once people learn that, they might have more skepticism regarding the long-dated pension-like promises that the government makes, because they can look at the future payment stream, and say, “I can’t see how we fund that.”

All for now.